Derivatives exchanges fed bitcoin crash

Leveraged trading platforms played a big part in driving last week’s price collapse in bitcoin and ethereum, says a cryptocurrency fund manager.

On March 12th bitcoin dropped from $7,800 to below $4,000 per coin, marking the worst single-day price decline in seven years. Ethereum suffered an even larger fall, plunging over 50 percent. Prices on different trading venues became severely dislocated during the crash.

Bitcoin has since recovered around two-thirds of its losses, trading at $6,550 on March 20.

Kyle Samani, managing partner at Multicoin Capital, says that derivatives exchanges like BitMEX, Binance, FTX and Deribit played a particular role in turning an initial, coronavirus-inspired drop in cryptocurrencies into a crash.

According to Samani, crypto markets’ structure ‘broke’ during the downturn. He says that although a similar crash is unlikely to happen again in the near term, it could well recur in future.

“In their current forms, the bitcoin and ethereum networks cannot operate at global scale,” Samani said in an essay posted on the Multicoin Capital website.

“During times of crisis, they become so congested that arbitrageurs cannot keep prices in line across venues, causing massive dislocations on individual exchanges.”

The Multicoin Capital partner says that high levels of leverage, differing collateral requirements on derivatives exchanges, network congestion and stale price feeds all played a role in feeding last week’s crash.

Some unregulated cryptocurrency derivatives exchanges offer leverage of over 100 times to clients who can sign up with just an email address.

A week before last week’s crash, the UK’s Financial Conduct Authority issued a risk warning against one popular derivatives exchange, BitMEX.

According to Multicoin Capital’s Samani, cryptocurrency derivatives exchanges often only accept specific forms of collateral from their highly margined clients.

Binance, for example, supports a few different forms of collateral for futures and perpetual swaps in bitcoin, but only tether as collateral for leveraged trades in ethereum, Samani says.

Meanwhile, BitMEX, which regularly trades billions of dollars a day of face value in bitcoin derivatives, only accepts the same cryptocurrency as collateral.

As traders cannot cross-margin positions across exchange venues, traders are often forced to liquidate trades at a particular exchange even though they might have a hedge elsewhere, says Samani.

A structural feature—sometimes called ‘negative convexity’—in the popular perpetual swap contracts offered by some cryptocurrency derivatives exchanges also fuelled the downtrend.

“If a trader goes long bitcoin using perps (perpetual swaps) on BitMEX, as the value of BTC drops, the trader loses money on the trade, and the value of the BTC collateral decreases,” Samani wrote.

“This intrinsically creates risk for liquidity providers on BitMEX. When the market moves more than 30% in a day, even traders with relatively mild amounts of leverage start getting liquidated.”

Exacerbating downward price pressures last week, exchanges do not credit immediately the accounts of users who wish to deposit funds, says Samani.

This is because any counterparty transferring cryptocurrency across public ‘blockchain’ networks usually waits a few blocks for a transfer to be considered final.

Settlement in cryptocurrency is probabilistic, rather than being considered final at a single point in time at a particular location.

“It generally takes at least 10 minutes after a block containing the deposit transaction is confirmed, and can take up to 60 minutes. During periods of high activity such as March 12th, a trader may have to wait several blocks to get their transaction confirmed,” Samani wrote.

And the stale price feeds received by decentralised finance (‘DeFi’) protocols also fed the crash, says Samani.

Slow price feeds were a factor cited by many observers as a contributing factor to the insolvency of decentralised, automated lending platform MakerDAO.

“Virtually all price discovery happens on traditional exchange venues as opposed to using DeFi protocols, with only a few exceptions. As a result, DeFi prices lag centralized venues,” said Samani.

MakerDAO has undergone a recapitalisation this week.

“The biggest take-away from this is that crypto market infrastructure is still immature. There is a lot of room to improve along many dimensions, and therefore a lot of investable opportunities,” Samani wrote.

He disclosed in his article that Multicoin Capital holds positions in bitcoin, ethereum and three stablecoins (crypto tokens pegged to the value of a fiat currency): MakerDAO’s ‘dai’ stablecoin, tether, a stablecoin associated with the Bitfinex exchange, and USD Coin, issued by Coinbase, another exchange.

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